Psychological Law of Consumption is based upon his observations can conclusion derived from the study of consumption function. Consumption function is the functional relationship between the income and consumption of the people. This can be stated as follow as follows:
C = f(Y)
Where C shows the consumption expenditure, Y shows the level of income and F indicates the functional relationship between them.
When the aggregate income of a person increase, his expenditure on consumption would also increase, but the increase in the income. This is because as the income increase, more and more of wants are satisfied. Hence, comparatively less and less is being spent when income increase. Of course, consumption expenditure does increase when the income rises, though only by a small amount.
The second proposition relating the law of consumption is that with an increase in income, the additional income will be divided in some proportion between saving and consumption. This obviously follows from the first proposition. Since the expenditure on consumption does not increase at the same rate as an increase at the same rate as an increase in income, a part of income is bound to be saved. Thus, consumption and savings go hand in hand. what is not consumed , is saved.
The third proposition regarding the law of consumption is that with the increase in income, both saving and spending would go up. An increase in income is unlikely to reduce the level of consumption and saving from their earlier position. It is not generally seen that a person decrease his consumption when the income increases. In fact, when the income rises, he would spend a little more than before And at the same time is savings would also be a little higher than the previous level.
These three observations regarding the behavior of consumption with an increase in income have come to be popularly known as Keynes’ Psychological Law of Consumption. The law, as enunciated by these observations would hold good on by when the following three assumptions are satisfied.